Amazon Shares Could Appreciate by 20%

Dec.19.08 | About:, Inc. (AMZN)

This week both Jeffries & Co and UBS initiated coverage of Amazon (NASDAQ:AMZN) (and Sanford Bernstein downgraded the stock to Neutral today). Both initiated with Neutral ratings and price targets in the low $50s, near the current stock price. I have not read their reports so I do not know their thesis. Currently, 30 sellside analysts cover the stock, with 9 Buy ratings, 3 Sell ratings, and 18 Neutrals. Price targets range from $25-$73, with a mean price target of $52. I argue that Amazon's stock price could appreciate by 20% from current trading levels.

Valuation. Amazon currently trades at 30x '09 GAAP EPS, which is above the Internet peer group. The Bears on the stock often point to this rich multiple as reason to stay on the sidelines. However, when I adjust the multiple for my EPS growth expectations over the next 3yrs (25%), I arrive at an '09 PEG of 1.2x, which is in-line to below the peer Internet group. That's an in-line PEG for a company with faster growth prospects compared to peers, is taking market share, is still on a growth trajectory, generates significant free cash flow, and is well capitalized . On that basis, I think the stock is cheap and has room for more upside.

My DCF price target based on a WACC of 10% an a 3% terminal growth rate produces a price target of $65. Using a reasonable 12x EBITDA multiple (EBITDA growing 18% over next 3yrs) to my 2010 EBITDA estimate yields a price target of $63. My model has Amazon generating $2.10 in GAAP EPS in 2010, but let us be conservative and round that down to $2.00, then applying the current trading multiple of 30x to that figure would yield a price target of $60. [I actually believe that Amazon can deliver GAAP EPS far north of $2.00 in 2010, so I maybe understating the value here.] Average the three gets me to a price target of $62, which represents 20% upside from current trading levels. The price target takes me to a target PEG of 1.45x, which is not egregious, and is still far from the PEG of +2.0x Amazon traded at as recently as this year.

4Q08 Expectations. The near-term story for Amazon is, of course, how 4Q08 comes in and what the company guides for 2009, so there is significant downside risk to the stock price if the company misses street estimates on both, with the 2009 guidance carrying more weight, in my view.

Consensus estimates have Amazon generating revenues of $6.549 billion and GAAP EPS of $0.44, so that's the bar for Amazon, although I suspect that analysts are likely to take numbers down ahead of the earnings report. Consensus is also estimating a 5.0% pro-forma operating income margin, which is down from 5.3% in 3Q08 and 5.8% in 4Q07. Management's guidance for both revenues and operating income was unusually wide. But the key will be how much revenues Amazon generates.

ComScore is forecasting flat YoY growth for online retail in the U.S. and according to analyst Mark Mahaney from Citigroup, comScore has tracked the Department of Commerce (NYSE:DOC) data closely in the past. Per the table below, the difference between Amazon's North American growth rates (which includes Canada) and the DOC reported growth rates for eCommerce in the U.S. has been on the order of 20% or so in the past several quarters. I average it to 22%. Thus, if comScore is predicting flat YoY growth for online retail in 4Q08 and their number has historically tracked the DOC numbers, then Amazon's North American growth rate should come in at 22%, which is above the 20% estimate in my model. So I am comfortable here.

For international, see my previous writeup about the weakening dollar here, but I believe the latest weakness in the dollar should help international revenues come in stronger than expected. So I am comfortable that Amazon should at least meet the consensus $6.55 billion revenue number for the quarter. That was long-winded but you get the point. Margins are another story and are difficult to get a read on going into the quarter but I imagine that Amazon is following the pack and controlling costs.

For 2009, Consensus is calling for revenues of $21.7 billion, GAAP EPS of $1.56, and pro-forma operating income margins of 5.4% (similar to 2008). Amazon only provides guidance on revenues and operating income. Guiding below either one of these two numbers will drive the stock down after earnings. I think currency may come in to help here as the dollar continues to weaken. So there is a greater likelihood of Amazon providing guidance that is at the mid-point higher than consensus estimates.

1. Amazon has a strong global brand, a wide selection of items, low prices, easy to use website and great technology that will likely continue to drive both new and repeat consumers to the site. This forms the basis for Amazon's huge competitive advantage.

2. Competition both online and offline is struggling through this recession, with many going out of business. So Amazon is likely to gain share in this recession.

3. Structurally sound business model. Company is likely to exist for several decades, cannot say that with confidence for any retailer, except Walmart.

4. Even though customers can order from Amazon from anywhere in the world, Amazon has its foot on the ground in only seven countries. Therefore, there is amply room for it to expand its physical footprint and drive incremental sales. Compare that to eBay which has a physical presence in several more countries. We do note that a direct comparison cannot be made here because eBay does not need physical warehouses to operate its model.

5. There are expansion opportunities into several more categories in the countries in which Amazon currently operates.

6. Low capital requirements with capex historically at less than 2% of sales.

7. Amazon Web Services, VOD, and other initiatives are higher margin businesses that could help sustain current margins, pressured by low prices, shipping offers, and mix shift. They also help Amazon drive incremental retail sales (cross sell), in my view.

8. Well capitalized with a healthy balance sheet with close to $2 billion in net cash and the company has delevered the balance sheet over the year so it is not burdened with debt payments. Amazon also generates over $1 billion in free cash flow per year. Management has returned value to shareholders via $500mn in recent share repurchases and currently has $1 billion left in authorization (however, as the stock price increases, Amazon is limited in its ability to buy back shares).

Amazon's challenges are mostly macro in my view.

1. A recession leads to lower ASP purchases and general apprehension about purchasing, hence revenues are negatively impacted. Against a high fixed cost structure (about 50% for Amazon) this will lead to lower margins. This is a macro negative that impacts all companies. However, it is important to note that Amazon's model is structurally sound and should weather through the economic downturn better than its competitors, both online and offline. Compare Amazon to eBay and other competitors, who are facing the headwind of a recession with a structurally unsound business model and some with weak capital structures. This is why we are seeing so many retailers shut their doors or exit several locations. Their business models cannot sustain a downturn in revenues. Amazon's business model can.

2. Amazon has weak visibility into 2009, but again every company faces that. Even GE failed to provide guidance for 2009 earlier this week.

3. With close to 50% of revenues coming from international locations, the strong dollar will pressure margins. This is also a macro effect. Note that the dollar has started to weaken against the Euro and the British pound, and it is hard to imagine that the dollar will not continue to weaken with near zero interest rates and the prospects of inflation revisiting the U.S. in 2009. See my previous write up on this topic.

4. In spite of all Amazon's positives including those like high inventory turns and a robust high margin 3rd party business, Amazon's operating margins GAAP or Adjusted are in the single digits. Investors will have to comes to terms with the possibility that Amazon may "NEVER" achieve double digit operating margins in their investing lifetimes. That is because Amazon will have to continue to invest is shipping offers, will have to continue to offer low prices, and will have to continue to spend to innovate, all in order to maintain their competitive advantage. That will limit the operating leverage in the model. My model has Amazon generating only 100bps of GAAP operating margins over the next five years. The other high margin non-retail products mentioned in the positives section are unlikely to become big enough to move the needle upwards on margins. At best they will help to sustain margins. Therefore, investors should move past the margin debate and focus on the fact that the company has ample room to grow, is gaining share, is well capitalized, and is generating significant amounts of free cash flow.

Disclosure: I am long Amazon.